No Easing in the European Crisis

Far from fading, it is all too probable that the European crisis will intensify over the course of the coming year.

The problem with consensus economic forecasts is that they generally prove to be wrong. As far as forecasting the European economy is concerned, the year ahead is likely to prove to be no exception. For rather than muddling along and beginning to recover as the consensus forecast would have us believe, it is more likely that the European economy will both sink ever deeper into recession and be beset by rising social and political tensions during the year. This makes it all too probable that, far from fading, the European crisis will intensify over the course of the coming year.

The consensus European economic forecast is that the worst of the crisis is now behind us and that a gradual European economic recovery will be underway before year-end. In support of that view, attention is drawn to the bold action of European Central Bank (ECB) President Mario Draghi, who in mid-2012 committed the ECB to do whatever it took to save the euro and who thereby managed to substantially bring down European government borrowing costs.

It is hoped that the ECB will now follow through on its commitment to buy as many short-dated Italian and Spanish sovereign bonds as it takes to keep the government borrowing costs for those two countries at reasonable levels. It is also hoped that the forthcoming German parliamentary elections in September 2013 will keep Chancellor Angela Merkel fully committed to supporting Draghi and to doing whatever else it might take to keep the euro together.

Sadly, there are two fundamental reasons to think that ECB action alone will not be sufficient to prevent a deepening European crisis. The first is that ECB support is premised on countries in the European periphery committing themselves to multiyear budget austerity programs along the lines proposed by the European Commission. Since those programs imply budget deficit reductions of between 2 and 3 percentage points of GDP a year at a time of economic recession, it is difficult to see how the application of such a severe degree of budget austerity will not lead to a deepening in the European periphery’s recession in 2013.

The consensus European economic forecast is that the worst of the crisis is now behind us and that a gradual European economic recovery will be underway before year-end.

This would particularly appear to be the case since the prospective fiscal policy tightening will be occurring at a time when the European banks continue to restrict credit and at a time when the global economic environment is now souring. This would hardly appear to be a recipe for economic recovery. After all, it was that very same policy mix of severe budget austerity at a time of a credit crunch that sank the European periphery deeply into recession this past year. There would seem to be very little reason to think that the application of similar policies under worse circumstances will produce any better a result in 2013 than it did in 2012.

A second reason not to be complacent about the European outlook despite strong ECB action is the political deterioration currently underway in the European periphery. It is all too likely that the austerity backlash and the crumbling of popular support for established political parties already evident across the European periphery will intensify in 2013. It will do so as the European economic recession deepens and as unemployment — especially among the young — continues to skyrocket. In this respect, it is well to recall that youth unemployment in Greece and Spain is already now in excess of 50 percent, which has to pose a real threat to political stability in those two countries.

A particular risk to the European economic outlook remains that of Greece finally exiting the euro despite a third IMF-EU bailout package that the country recently managed to secure. Such a risk could very well materialize were the Greek government to fall and be replaced by the extreme left Syriza Party, which is considerably ahead in the polls and which is vehemently opposed to continuing with IMF-EU dictated policies. Greece’s drift toward a state of un-governability together with the prospect that the Greek economy is officially projected to decline by yet a further 4.5 percent in 2013 would suggest that a possible fall in the Greek government in 2013 should not be lightly dismissed.

In the end, we might find that the consensus view turns out to be the correct view and that Europe does again muddle through the year. However, at present it would seem that all the clues are pointing in the opposite direction. And U.S. policymakers would be making a big mistake to think that the European economic crisis does not continue to pose a major risk to the U.S. and global economic recoveries.